Annuities: The Good, The Bad and The Ugly

Are Annuities Good, Bad or Ugly?It depends on your needs, and on the type of annuity. An annuity is a lump sum of cash invested to produce a monthly stream of income for a fixed period or for life. The income can start now (immediate annuity) or in the future (deferred annuity). Funds are not protected or insured by the issuers. The size of the future monthly check isn’t always a given – it depends if the annuity is fixed or variable.

Annuities come in all types and shapes. Since I don’t sell products and earn commissions, I’m wary of the motives behind many financial product sales….especially lucrative variable annuities:

Variable annuity salespeople earn sizable commissions; they can be very driven to sell this to you. Commissioned sales people are NOT required to put your interests before their own interests.

Annuities should be purchased only if there are compelling benefits and only if they compliment the “whole financial picture of an individual or couple.” Annuity sales people frequently are focused on “closing the deal” and do not consider the buyer’s entire financial picture.

Annuities aren’t for everyone. If you receive Social Security, you already have a fixed, indexed annuity that pays you for the rest of your life. If you have a pension, you have a fixed annuity that pays you for life. If nothing else, the insurance element of an annuity means you “lose” if you live a shorter life than your peers since the insurer redirects monthly payments to other annuity investors who outlived you.

So what are good, bad and ugly annuities? Here’s my smell test for annuities:

THE GOOD:

If you’re a high income earner in a high tax bracket, low cost variable annuities can make sense if you’ve completely maxed out your 401(k) and IRA deferrals and you expect to be in a lower tax bracket when you retire. Low cost variable annuities charge less than 1% per year.

A low cost fixed or variable annuity may make sense if you want to convert a lump sum into a stream of income and you can afford to tie up a certain amount of your money for an extended period of time (possibly forever).

“Longevity annuities” may be prudent if you’re concerned about outliving your assets and you have the means to lock up some of your assets in an annuity. Longevity annuities can be set up to begin a stream of income late in life. For example, Alice is 73, in good health and has longevity in her family. She puts no more than 15% of her investments into a deferred fixed annuity. Alice will begin to receive monthly income from the $150,000 investment when she turns 80; these payments will continue until she passes away. If she dies before receiving any payments, the principal may be returned to her without interest, but she may forfeit the entire annuity if she passes away after she begins to receive her stream of income.

The government has new initiatives to allow 401(k) investors to put a portion of their account into an annuity. The government is concerned about poor 401(k) returns because investors don’t always invest wisely; the annuity option is seen as a way to provide some greater element of predictability and certainty to retirees.

Charitable annuities can be a wonderful way to make a tax-deductible donation to a charity and to receive a portion of the donation as a stream of income for life.

THE BAD AND THE UGLY:

Variable annuities can tie you down with 3-4% annual fees and severe (up to 15 years or longer) surrender penalties.

Are you looking at variable annuities with bells and whistles that you really don’t understand (starting with the “seems too good to be true” illustrations you’re being shown)? If so, I recommend a 2nd opinion from someone who has no skin in the annuity game.

Are you in a low or moderate tax bracket? Buying an annuity with after-tax dollars (to defer investment income) may disappoint if your income tax bracket ends up as high or higher in retirement due to a) significant RMD distributions from an IRA or 401(k) and b) the fact that tax rates overall likely will rise further in the future.

Further, if you purchase an annuity with after-tax money, it may be a poor tax decision. You’ll be swapping lower capital gains tax rates on taxable income to higher ordinary income tax rates on all annuity gains.

You don’t need an annuity in an IRA if you’re looking to defer income since the IRA already is tax-deferred. Holding an annuity in an IRA is largely redundant unless you specifically are seeking the insurance/mortality benefit.

A fixed annuity may augment your overall financial/investment strategy but interest rates currently are unappetizingly low. You’d be better off buying a fixed annuity that locks in higher interest rates when interest rates are higher.

Your money may be tied up for life. After-tax annuities can’t be undone – once the money is in an annuity structure, it remains in an annuity structure. If you need or want to exit a bad or ugly annuity, you can roll it over to a less expensive annuity if you no longer have surrender penalties. However, you can’t terminate the annuity structure.

Are you planning to leave your heirs your variable annuity? Annuities invested in equities make poor inheritances since there is no step-up in basis to the date of death value of a position when the initial owner (annuitant) passes away.

In sum, fixed annuities can be attractive for some people when interest rates move higher. To my mind, variable annuities have more “cons” than “pros” and should be purchased only after you’ve done your due diligence and received an unbiased 2nd opinion. Otherwise it's Caveat Emptor! (Buyer Beware).

I established Kaplan Financial Advisors in 2004. My firm provides comprehensive financial planning and investment management for pre-retirees and retirees. I work with many single women. My clients come from throughout NJ and nationwide. My investment management minimum is $...